Conference Call, 07/22/98, Innovex Q3

FOOL CONFERENCE CALL SYNOPSIS*
By Jeff Fischer (TMF Jeff)

Innovex Inc.
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1313 5th Street S.
Hopkins, Minnesota 55343
(612) 938-4155
http://www.innovexinc.com

ALEXANDRIA, VA (July 21, 1998)/FOOLWIRE/ -- Electronic component manufacturer Innovex reported third quarter 1998 earnings of $2.41 million, or $0.16 per share, on revenues of $20.29 million. Earnings were on par with recently lowered estimates.

Results were inferior compared to last quarter (and last year) due to continued weakness in the disk drive industry, sales mix, the ramp of new production facilities (this knocked 5% from net profit margins), and ongoing technology innovations. New flex assemblies require fewer lead wires per drive, meaning Innovex -- a company that makes most of its money on lead wires -- achieves lower sales. Management is of course addressing this with new initiatives.

Conference Call Business Summary. As stated a few calls ago, Innovex felt that it was looking at a difficult few quarters in the future. It has been tougher than anticipated, yet Innovex is still one of the few disk drive companies to be profitable over this time period, and says "we're proud of that." Now Innovex is doing increased internal planning based on the fact that the current quarter will be very similar to the quarter that just ended. The company is prepared for any upturn in business -- which might come by the December quarter though nothing is certain -- but management has also reconfigured costs in order to operate well in the current slow environment.

In regards to internal planning, Innovex has cut costs commensurate with declining sales volume. Volume in the disk drive industry overall has greatly decreased the past year. Also, other technological factors are working through Innovex's numbers. When selling its newer head interconnect flex (HIF) product, every one of these flexible circuits cuts away one lead wire, meaning less lead wire sales for Innovex. Other company products are taking away lead wires, too, though lead wires are still by far Innovex's large volume product. The company has continued to increase the production facilities at its Litchfield Precision division for future demand. In the next quarter, continued demand for HIF is on tap, and in September Innovex's new flex suspension assemblies (FSA) will be available for evaluation by clients.

InnoMedica, Innovex's former medical parts division, has been successfully sold. It has little to no impact on the company's balance sheet, sales, or earnings.

Again, going forward the fully completed flex suspension assembly product (FSA) will be available to customers in the September quarter and ready for production volume in the December quarter. With that, "We open the call to your questions."

Q & A Session (answers to questions follow)

Details of the New FSA Product. This Innovex product takes the head interconnect flex circuit (HIF) and attaches it to a suspension. Early tests show outstanding results. Innovex is doing this because most customers want the flex circuit attached to a suspension (they don't want to do it at their own facilities), so Innovex is providing customers what they want. The company is very close to getting production equipment in place and will have the capability to ramp in December.

Innovex will not make the suspensions itself, but will purchase them from one of many suppliers, or, actually, from many different suppliers. The suspension business is low margin and there is plenty of attractive pricing out there for Innovex to choose from, so it won't get into the business itself. Innovex has no exclusive relationship with any specific suspension supplier. It will work with the customers' desired suspension company in each individual case. Innovex wants to maintain relationships with all suspension suppliers.

In the past, Innovex has sold the flex circuit to a recording head or disk drive manufacturer and they had been attaching that to the drive system. In the future, Innovex will be sending the flex circuit pre-attached for the companies that wish. The process of attachment that Innovex developed is low cost and extremely precise. Of course, sales volume for this new product will depend on how many disk drive programs Innovex obtains.

Exiting calendar 1999, the company should have capacity for 3 million pre-attached units per week. During calendar '99, the ramp for this capacity will increase capital expenditures by about $5 million to $7 million. The product requires only low cost machines, so the capital expenses do not rise significantly. Finally, the cost per FSA unit sold will be design dependent and different for each company, but the cost will be in the dollar range, plus 20%, minus 10%. This is currently much lower than the competition [which is reportedly around the $2 range, plus up to 20%].

The competition has done pioneering work in this vein, but Innovex is inviting customers to its facilities and showing what they'll soon offer in one package. A few customers could begin to see a volume ramp by the end of this year or in the early new calendar year. This volume ramp will happen in new drive programs. Customers with reduced design cycles can be ramped up early next year, while other slower or less advanced customers are more likely to ramp mid next year.

As for customer demand, Innovex feels extremely comfortable with the interest shown not only from current customers, but also from new customers. New customers didn't want any assembly to do, so now Innovex is offering to do it for them. Next, Innovex needs to prove the viability of its technology to new customers and let the pricing advantage speak for itself.

Breakeven on new FSA products will be well under 500,000 units per week. On HIF alone, breakeven was under 200,000 to 300,000 units per week, and attaching the suspension doesn't add much cost. Attaching the suspension will lower overall corporate gross margins, but at the same time add to sales volume with new customers and increased orders.

Past Quarter Sales Volume and Mix. As expected, Magneto Resistive (MR) product represented over 90% of volume in the past quarter, compared to about 83% in the prior quarter. Pricing per unit dropped about as expected, while customer mix issues changed overall average prices during the quarter to the downside. Prices dropped by greater than 10%, but a good portion of that was based on this customer mix issue. Certain customers are charged lower prices, so if those customers place large orders the average price per unit drops, of course. In the current quarter, Innovex expects this to change to the upside.

The company shipped about 5.5 million lead wire units per week this quarter (compared to nearly 7 million last quarter, and nearly 11 million at the peak last year). Shipments were flat throughout the quarter, and current run rate is at about the same 5.5 million now. Innovex has lost a certain amount of overall volume to other competing interconnect products that require less lead wires per unit (so Innovex sells less lead wires when it does sell). The company believes that once it has its complete line of FSA products to the market, it will win customers back, because it will have the technology advantage and the best pricing however you look at it.

HIF sales were between 500,000 and one million units per week the last quarter. Sales began at one million per week and ended at one million per week, varying in between, but now seem to be on an upward trend. Seagate is the only high production customer, but prototype pre-production quantities have been shipping to several customers for a few months.

Overall, Precision Products was 76% of revenue and Litchfield Precision Components about 22%. During the ramp of facilities at Litchfield, the division remains profitable and is increasing profitability. Expenses of building up the new facility lowered margins by about 5% this quarter, and the new facility is only operating at 20% capacity thus far. Margins will improve with throughput efficiency and with volume.

The Chip Packaging Biz. Innovex continues to be in qualification for this business, and isn't suspecting significant volume until early calendar 1999 -- so, in six months. Management is confident in the business, and the company continues to make progress and qualifications are going very well. Innovex feels that it will be a significant revenue generator and gross margins should be in the traditional high range that Innovex aspires to. As for operating margins, this new business might first naturally require more marketing and sales, but not any incredible amount. Management can't comment on projected revenue for chip packaging, but it could be significantly over $20 million a year once ramped -- but that isn't a forecast and it's too early to say.

At that level or a level close to it, Innovex will have traditional gross margins and this will help diversify its customer base and business risk as well. Growth in this industry should be 40% to 50% year-over-year, and it is a much larger market than the disk drive market that Innovex currently serves. Advantageously, the majority of the process that exists for Innovex's disk drive business works for the chip packaging business as well, so the company can leverage much of the equipment that it already has.

IBM's GMR Technology. Innovex doesn't believe that this will have any impact. GMR will require interconnect just like MR does.

Cash on Hand. A share buyback could be on the agenda this Friday at a Board meeting, but there are no guarantees. Management has looked at other ways to use the growing cash position, too. Also, in relation to the stock, Innovex does have few presentations to new brokerage houses for potential additional coverage, but that will be a couple of months away.

Iconovex. This week the software division, Iconovex, will have a demonstration for another customer. To date, it hasn't signed any more deals since the one announced last quarter.

Main Customers. These haven't changed. Some were higher, some lower, and different products (with different margins) are sold within Innovex's customer base. The top three customers remain Yamaha, Read Rite, and Seagate, and second-tier customers are Applied Magnetics, TDK, SEC, and Quantum.

Innovex serves everyone in the disk drive industry, though, and it doesn't announce when new programs begin with any one customer.

Precision Products Equipment. As lead wires are phased out by new technology, this production equipment has many other possibilities. The hearing aid market is one opportunity, and is an industry Innovex is surrounded by in Minnesota. This lead wire equipment has been depreciated already and come next year basically all of the capital expenditure on this equipment will have been depreciated.

1999 Research and Development Cost. Some increase in R&D will occur for new products and ramps, but as those new products ramp, this expense will remain about the same or even drop off some. On an absolute basis, it will grow with revenues. Also, the sale of InnoMedica lowers this expense some, so other Innovex businesses can increase this expense now and still keep total R&D expenses in line.

Future Businesses. The disk drive market might be only about 1/3 of Innovex's business within five years. That is the goal. Innovex is aiming to triple the revenues of last year ($142 million) over the next three to five years, with chip packaging and other businesses being about 2/3 of total sales. As for acquisitions, it is always looking in certain related fields.

Insider Trading. Mostly a few sells over the last quarter. The company has 30-day trading windows each quarter that all insiders must abide by. They can only trade during these 30 days every quarter. About four people did sell last quarter, with most of that being to rebalance portfolios, while some folks had retired. Any sales and purchases in the future will also be during a certain 30 day period.

Inventory Practices at Customers. Most disk drive companies have much lower volume production now. There are a couple things that impact Innovex: disk drive heads now need less lead wires, plus now is a stagnant period of demand for additional memory. Also, to some degree companies are funneling money into the year 2000 problem at the expense of buying more hardware.

Conclusion

"We showed a profit and intend to continue to show a profit." Innovex will proceed with its R&D initiatives, and in the long run management reiterates that it expects to win the "interconnect to the head business" that it has dominated since the beginning for thin film heads. It will be "dominant as well in the future."

End.